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Sector funds may attract undisciplined investors

By Kate McCaffery | December 19 2011 06:56PM

Sector fund sales are an interesting thing to observe if you’re interested in whether or not investors are chasing specific trends.
Used by some to legitimately tilt a portfolio towards particular sectors in an effort at diversification, the funds also tend to attract undisciplined investors who are lured by returns after any given sector has a good run.
Although the goal of such investment moves is to boost returns (and add some diversification), Dan Hallett, vice president and director of asset management at Highview Financial Group says the theory breaks down in practice. After doing calculations on investor returns since 1998, he’s found that investors generally realize lower returns in funds that are more volatile. “Since sector funds are more volatile than broader equity funds, investors tend to do relatively poorly in these popular funds,” he says.
Precious metals
Recent performance numbers from Morningstar Canada show that natural resources equity funds gained 11.3 per cent in October. Precious metals equity funds meanwhile, gained 3.2 per cent, followed by the real estate equity fund index at three per cent. Financial services gained 2.3 per cent and the healthcare equity index added 1.2 per cent.
“In spite of some struggles in 2011, a lot of the categories have done well,” says Morningstar fund analyst, Adam Fisch. Still, he says inflation-protected fixed income and long-term fixed income funds continue to top the list. “This would play into investor fears about inflation and the downturn,” he adds. “These suggest that people are worried about inflation, they’re not too concerned about an increase in interest rates and that they’re trying to capitalize on that view.”
When looking at three-year returns, he says precious metals funds are “by far” out in front of the rest. “After the economic recovery in 2009, there was a bit of a run up on those stocks so it’s not surprising. As investors get more comfortable with risk, after the downturn there was a bit of a rush towards those categories,” he says. “A lot of the riskier categories are near the top. Those tend to perform well in strong markets and struggle in down markets. Over the last three years, the up-market heights outpaced the down so natural resource equities and emerging markets are all at the top, in spite of struggles.”
When looking at sector fund sales, Sandeep Gosal, senior analyst at Investor Economics says sector mutual fund net flows (sales), with one exception in 2006, have all been positive since 2001. That said, sales have been somewhat muted, never exceeding $1-billion during the last 10 years.
At the high point for sales between 2007 and 2009, sales reached between $850-million and $970-million each year. Prior to that, he says net inflows were much smaller, ranging between $200 and $500-million.
The numbers also show a disconnect between performance and sales. Healthcare funds, for example, have performed well but the funds have been in net redemptions – to the tune of about $2 million – since 2008. At the opposite end of the sales charts is natural resources funds. Not surprisingly, those invested in precious metals and energy, are taking in the bulk of new sales with gold funds taking in the majority of new assets over the last three years. Although the funds are in net redemptions today, back in 2008 and 2009 the category took in just under $700-million each year. “Most of the activity was centered around gold and resource funds,” Mr. Gosal says.
In other categories, he says science and technology funds have been in net redemptions since 2002. Although sales are mixed over time with relatively small net redemptions under $100-million, financial services saw significant redemptions of $101 million in 2010 while energy funds added $200 million in net new sales.
“Overall though, when you look at sales on a year-to-date basis in 2011, sectors funds have just over $400 million in sales. The previous year, there’s about $300-million. Between 2007 and 2009 there were between $800-million and $1-billion in new sales each year.”
Exchange traded funds
For those who are seeking sector exposure, exchange traded funds are a relatively new option to consider as well. At the end of 2004, sector ETFs held just under $1-billion. As of September 2011, that number had grown to $8.7-billion. By comparison, sector mutual funds in 2004 held $10.7 billion in assets. Today, they hold more than $21 billion. Most of the ETF growth is driven by manufacturers entering the commodity space.
With a few exceptions, most gold and commodity mutual funds invest in the equity securities of companies involved in development, production and exploration. On the ETF side though, products sometimes track the futures contract price for specific commodities. A few ETFs also invest directly in gold and gold certificates. Of the $8.7-billion invested in ETFs at the end of September, Investor Economics says $3.2 billion was invested in natural resources. Within that number, $2.4 billion was invested in gold and gold-related products.
The ETFs make a fee comparison more interesting than it might normally be too. Although ETF management fees are generally lower, some also have forward contract fees and performance fees, not to mention the brokerage fees to purchase in the first place.
Interestingly, the assets held by mutual fund wrap programs make up a relatively small amount of the total amount invested in sector funds. Mr. Gosal’s research shows that only $1.4 billion in assets came from fund wraps. “I thought it would be higher,” he says. “They’re really not being used by fund wraps, it seems. Most of the sales are coming from standalone fund sales. It would be interesting to ask an advisor how they’re using them. Are they using them to help clients diversify or get exposure to particular sectors or are they simply chasing hot asset classes?”
Broader based funds
Mr. Hallett says most investors should probably stay away from investing directly in sector funds. “My suggestion to investors or advisors who have a view on specific sectors is to seek out managers with a similar view. Want a global fund with little in the U.S. or Europe and more invested in higher growth emerging markets? Buy a global fund that fits this description. Think commodities have a way to go still? Then look at Canadian funds run by managers sharing that view,” he says. “Buying sector funds directly explicitly shifts active management decisions into your own hands. Most would be better to find broader based funds managed by skilled managers who share the same view.”

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